Divergence between the U.S. and other Economies Keeps Dollar Bull Case Alive

Our underlying constructive outlook for the US dollar remains intact. It is broadly based on the divergence between the US and most other major economies. The US acted early and aggressively to counter the Great Financial Crisis. Unorthodox policies, such as quantitative easing, were adopted years before the ECB and BOJ. This has produced different outcomes. US economic growth may not be impressive by pre-crisis standards, but it does not seem particularly fragile.

The Federal Reserve may be normalizing monetary policy more gradually than we anticipated, but the ECB and BOJ are more aggressive. Although there was a scare around the UK referendum, the derivatives markets clearly show that the next Fed move is a hike, not a cut. Many observers expect the ECB to ease by changing from the capital key to a debt market measure to guide its sovereign bond purchases.

This would reduce the quality of assets being bought, which some economists regard as more aggressive policy. Many also expect that the ECB will announce in Q4 that it will extend its purchases, which have a soft end-date of the end of Q1 17, after having been extended once already.

The BOJ is expected to ease policy as early as next week. It may be part of a larger fiscal-monetary initiative to strengthen the economy and arrest falling prices. The Bank of England gave as clear a signal as can be reasonably expected that it will ease monetary policy next month. Australia and New Zealand may cut rates next month as well.

At the same time, the US economy appears to have accelerated in June, and that momentum should carry into Q3. The service sector ISM was the best of the year. Jobs recovered from May's fluke. Manufacturing and industrial output strengthen. Retail sales were stronger than expected, and price pressures were slightly firmer.

The Dollar Index is not a good proxy for a trade-weighted index. Two of the US largest trade partners, Mexico and China, for example, are not included. However, for a rough and ready proxy, the Dollar Index may be useful. After trading broadly sideways in in H2 13 and H1 14, the Dollar Index rally from around 80 in mid-2014 to 100.50 by the end of Q1 15.

It has not made a new high since, and this spurred speculation that the dollar's rally is over, that the divergence meme has been fully discounted. We see it a bit differently. The broad sideways movement in the Dollar Index since March 2105 has primarily a consolidative phase, from which it will launch another leg higher.

After a big run-up, it is not unusual to have a counter-trend move. Technicians look for retracements of the rally to determine whether it is corrective or a reversal (start of a new trend). A common minimum retracement is 38.2%. The Dollar Index flirted that retracement objective (~92.55). It penetrated it once (early May 2016), but never closed below it. This suggests that the uptrend is still intact, and the sideways movement was corrective in nature.

Today the Dollar Index is trading at its highest level since March. It is approaching a downtrend line drawn off last December's high and the highs from late-January and early-February. Depending on how the line is drawn, it comes in between 97.40 and 97.75. In addition, the 97.20 area corresponds to a retracement objective (61.8%) of the losses seen since last December's high. Technical indicators on the weekly bar charts like the RSI and MACDs are consistent with additional dollar gains.

While the 100.50 area, a little more than 3% from current levels is the upper end of the 18-month range, we look for this to give way in H2. Our target above there is 101.80, and a move through there would likely coincide with the euro approaching parity.

Professor at Columbia University. Recipient of the Nobel Memorial Prize in Economic Sciences in 2001 & the John Bates Clark Medal in 1979. Author of "Freefall: America, Free Markets", "The Sinking of the World Economy", "Globalisation and its Discontents" & "Making Globalisation Work".

Chancellor of the Exchequer of the United Kingdom from 1992 to 2007. Prime Minister of the UK between 2007 and 2010. Inaugural 'Distinguished Leader in Residence' at New York University. Advisor at World Economic Forum

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